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Delaware Law, Voidable Transactions, and the Implications for the Duty of Loyalty: SPTA v. Volgenau 

One classic example of a shift in Delaware law to the detriment of shareholders occurred in connection with a misapplication of Section 144 of the DGCL.  The provision deals with transactions involving director conflicts of interest and provides that no agreement shall be "shall be void or voidable" as a result of the conflict where the transaction is approved by shareholders, disinterested shareholders, or is otherwise fair. 

The meaning of the provision is plain.  It was intended to prevent conflict of interest transactions from being voidable (something that was possible under the old common law standard).  Nonetheless, Delaware courts have misapplied the provision and used it to significantly change the standard of review for conflict of interest trnasactions.  The courts have concluded that Section 144, if properly used, results in the application of the duty of care rather than the duty of loyalty to a conflict of interest transaction.

The incorrect nature of the interpretation is clear from the language of the statute (it speaks only to voidability) and from the standards set out in the statute.  Voidability is avoided through a showing of fairness, approval by disinterested directors, or approval by shareholders.  Despite suggestions by the Delaware courts to the contrary, the statute does not require approval of the transaction by disinterested shareholders.  Thus, if Section 144 were read to change the standard of review (instead of addressing only voidability), it would effectively be allowing a change in the standard in the unjustifiable circumstances of approval by interested shareholders.  For a more detailed discussion of this issue, see Returning Fairness to Executive Compensation

We note all of this because of the recent decision by the Chancery Court that shows how Section 144 ought to work.  In Southeastern Pennsylvania Transportation Authority v. Volgenau, 2012 Del. Ch. Lexis 206 (Del. Ch. Aug. 31, 2012), the court had to interpret Section 124, the ultra vires provision.  The provision provided that "[n]o act of a corporation . . . shall be invalid by reason of the fact that the corporation was without capacity or power to do such act" but provided that the lack of authority could only be raised in certain circumstances, including "a proceeding by a stockholder against the corporation to enjoin the doing of any act or acts".

Plaintiffs challenged a merger approved by the board and argued that the transaction was ultra vires because it violated the articles of incorporation.  Defendants sought dismissal of the action alleging that plaintiffs had not met the requirements of the statute because the action was for damages, not an injunction.

The court declined to dismiss the action, however.  It noted that Section 124 spoke to voidability, that is a claim "that the act could not occur."  Actions by corporations that are not voidable under the statute could still be challenged as a violation of the board's fiduciary obligations.  The court noted that the Section did not speak to fiduciary obligations.

The General Assembly could have stated in 8 Del. C. 124 that a director's decision to cause a corporation to take an act in violation of the corporation's certificate of incorporation shall not constitute a breach of that director's fiduciary duties. But the General Assembly did not do that. Instead, it enacted a statute directed solely to the acts of corporations that are beyond challenge or that may only be challenged in a limited manner.

The same paragraph could have been written about Section 144.  The provision references voidability but says nothing about fiduciary duties.  Nothing in Section 144 addressed the right of shareholders to challenge transactions that were found not to be voidable.  In other words, the standard of review for these transactions is a matter of common law, not a matter of statutory mandate. 

The inapplicability of Section 144 matters.  To the extent that the courts want to provide benefits to boards that use a disinterested approval mechanism, they have the flexibility as a matter of common law to decide those benefits.  Delaware courts already provide that disinterested approval of transactions with controlling shareholders (a type of transaction not expressly covered by Section 144) will not result in a shift from the duty of loyalty to the business judgment rule but simply results in a shift of the burden of showing unfairness to the challenging shareholders. 

A shift in the burden would mean that fairness still mattered.  The terms of the transaction would be relevant to the analysis.  Shareholders would not be limited to the impossible standard of waste.  The result would be a more exacting standard of review by directors and, in the case of executive compensation, downward pressure on amounts.  Yet as long as the courts point to Section 144, they can lay the blame for an inadequate standard of review at the feet of the Delaware legislature. 

Primary materials are posted on the DU Corporate Governance web site


Special Committees and the "Controlled Mindset" -- Americas Mining Corp. v. Theriault (Part 3)

As for the "controlled mindset" analysis of the Chancery Court, the Supreme Court had little specific to say about it. The Court mentioned it a few times and noted that an analysis of entire fairness required the Chancery Court to apply "a disciplined balancing test".  The Court concluded that the record reflected that this "balancing" in fact had occurred. 

The record reflects that the Court of Chancery applied a "disciplined balancing test," taking into account all relevant factors. The Court of Chancery considered the issues of fair dealing and fair price in a comprehensive and complete manner. The Court of Chancery found the process by which the Merger was negotiated and approved constituted unfair dealing and that resulted in the payment of an unfair price.

The case demonstrates that the traditional safeguards -- independent directors and independent advisors -- do not invariably protect shareholders.  Special committees can still be subject to excessive influence of the controlling shareholder. 

Nothing in the opinion, however, suggested any meaningful method of determining when this untoward influence existed.  The use of the term "controlled mindset" was really a conclusion rather than an analytical framework.  Indeed, the determination was reminiscent of Potter Stewart's famous analytical framework, "I know it when I see it."

The case does demonstrate that the special committee approach used by the Delaware courts has significant problems.  Yet the practice of replacing substantive fairness with process is a continuing trend in the development of Delaware law. 

Some primary materials from the Chancery Court are posted on the DU Corporate Governance web site.


Special Committees and the "Controlled Mindset" -- Americas Mining Corp. v. Theriault (Part 2)

The Supreme Court affirmed the approach taken by the trial court with respect to the burden shifting nature of the Special Committee.  The trial court was found to have been correct in assigning the burden of proof only after the trial had occurred.  As the Court reasoned:

The Court of Chancery could not decide whether to shift the burden based upon the pretrial record. After hearing all of the evidence presented at trial, the Court of Chancery found that, although the independence of the Special Committee was not challenged, "from inception, the Special Committee fell victim to a controlled mindset and allowed Grupo Mexico to dictate the terms and structure of the merger." The Court of Chancery concluded that "although the Special Committee members were competent businessmen and may have had the best of intentions, they allowed themselves to be hemmed in by the controlling stockholder's demands."

The inability to resolve the burden until after the trial resulted in "practical problems for litigants".  Nonetheless, it was an inevitable consequence of the standard.  

In affirming the lower court, the justices tried to minimize the impact of their decision.  The Court described the shift in the burden to the shareholders as a "modest procedural benefit" (emphasis in original).  In other words, boards gained only a modest value in seeing the burden shift.  Moreover, the assignment of the burden was not invariably outcome determinative as the facts in Americas Mining illustrated.  See Id.  ("The Court of Chancery concluded that this is not a case where the evidence of fairness or unfairness stood in equipoise. It found that the evidence of unfairness was so overwhelming that the question of who had the burden of proof at trial was irrelevant to the outcome."). 

In fact, a "modest" benefit probably overstated the value that came with the shift in the burden.  Defendants asserted that the failure to determine the burden shifting issue prior to trial would discourage boards from using special committees.  The Court disagreed, citing the value of special committees. 

That argument underestimates the importance of either or both actions to the process component—fair dealing—of the entire fairness standard. This Court has repeatedly held that any board process is materially enhanced when the decision is attributable to independent directors. Accordingly, judicial review for entire fairness of how the transaction was structured, negotiated, disclosed to the directors, and approved by the directors will be significantly influenced by the work product of a properly functioning special committee of independent directors.

In other words, the benefits of a "properly functioning special committee" weren't modest, they were insurmountable.  If the committee was properly functioning, the burden wouldn't merely shift.  IN effect, shareholders would be subject to an irrefutable presumption of fairness.   In effect, the standard of review was not really entire fairness but the business judgment rule. 

Some primary materials from the Chancery Court are posted on the DU Corporate Governance web site.


Special Committees and the "Controlled Mindset" -- Americas Mining Corp. v. Theriault (Part 1)

Americas Mining Corp. v. Theriault, 2012 Del. Lexis 459 (Del. August 27, 2012) got a great deal of press if for no other reason than the eye popping numbers.  The Chancery Court found (and the Supreme Court affirmed) that Southern Peru overpaid for the purchase of a company from a controlling shareholder.  The trial court awarded damages of $2 billion and attorneys fees of $304 million. 

The case also, however, contains some very interesting commentary on special committees.  In general, boards considering proposals from a controlling shareholder understand that the transaction will be reviewed under the entire fairness standard.  A review of entire fairness entails an examination of both amount paid and the process employed (fair price and fair dealing). 

To ensure proper process, directors commonly form a special committee.  The committee typically consists entirely of independent directors and the directors retain independent experts.  Where the company uses a special committee in this manner, the Delaware courts shift the burden to shareholders.  Rather than the board having to show that the transaction was fair, shareholders have to show that the transaction was unfair.  The shift in the burden, however, is based on the efficacy of the procedural protections provided by the special committee.  To the extent the process is somehow flawed, courts will not defer and the burden will not shift.  

For the most part, it is enough to form a special committee consisting of independent directors and allow them to rely on independent advisors.  In those circumstances, the committee typically receives a high degree of deference.  Shareholders have little or no ability to challenge the decision, even if the committee more or less accepts the offer from the controlling shareholder. 

The court in Americas Mining, however, did not follow the usual script.  The board of Southern Peru formed a Special Committee and staffed it entirely with independent directors.  Moreover, the Committee was "given the resources to hire outside advisors, and it hired not only respected, top tier of the market financial and legal counsel, but also a mining consultant and Mexican counsel."

Nonetheless, the trial court refused to defer to the Committee's decision.  Despite the independence of the directors and the use of independent consultants, the trial court found that the Committee was under the grip of "a controlled mindset" and, as a result, allowed the controlling shareholder "to dictate the terms and structure of the merger."  Said another way, the Chancery Court determined that "although the Special Committee members were competent businessmen and may have had the best of intentions, they allowed themselves to be hemmed in by the controlling stockholder's demands."

The conclusion of a "controlled mindset" did not really arise from any evidence of untoward influence by the controlling shareholder.  It mostly arose out of what the Chancery Court viewed as an inexplicable result.  The Special Committee had apparently been told by its financial advisor that under the terms of the proposed transaction, "Southern Peru would 'give' stock with a market price of $3.1 billion to Grupo Mexico and would 'get' in return an asset worth no more than $1.7 billion." 

Rather than negotiate a change in the sales price, the Special Committee sought to change the assorted valuations.  As the Chancery Court noted:  "[I]nstead of pushing back on [the controlling shareholder's] analysis, the Special Committee and Goldman devalued Southern Peru and topped up the value of Minera."  The result was a valuation placed on Southern Peru that was $1.1 billion below the NYSE market price.  The Chancery Court had this to say about the approach:  

A reasonable special committee would not have taken the results of those analyses by Goldman and blithely moved on to relative valuation, without any continuing and relentless focus on the actual give-get involved in real cash terms. But, this Special Committee was in the altered state of a controlled mindset. Instead of pushing Grupo Mexico into the range suggested by Goldman's analysis of Minera's fundamental value, the Special Committee went backwards to accommodate Grupo Mexico's asking price—an asking price that never really changed.

The Chancery Court, therefore, expected the Committee to ignore the "relative" valuation and somehow go back to the "fundamental" valuation originally provided.  Then, with two disparate sets of valuations, the Committee was supposed to negotiate a better deal with the controlling shareholder.

In effect, therefore, the court found an inexplicable result and concluded that it could only have arisen because of a "controlled mindset."  In truth, however, the Special Committee's actions were not very different from those of most other special committees.  Special committees often approve offers from a controlling shareholder and often rely on advisors that support the terms set out by the controlling shareholder. 

The defendants objected to the trial court's approach.  We'll look at the Supreme Court's reasoning in the next post.  Some primary materials from the Chancery Court are posted on the DU Corporate Governance web site.


Inspection Rights and Delaware Law: Elevating Process Over Efficiency (Central Laborers Pension Fund v. News Corp.)

The Delaware courts constantly come up with new ways of denying shareholders the right to access documents under the right of inspection in Section 220.  The credible basis standard is one.  Central Laborers Pension Fund v. News Corp., 45 A.3d 139 (Del. 2012) provided another. 

Plaintiffs sought documents from News Corp. They sent by overnight mail a request for documents on March 7.  See Complaint, at p. 19 (noting that the letter was delivered to News Corp on March 8, 2011, at 10:09 a.m).  According to the Complaint, the company did not respond within 5 business days and, as a result, they sought enforcement in the Chancery Court.  See 8 Del. C. § 220(c) (where company "does not reply to the demand within 5 business days after the demand has been made, the stockholder may apply to the Court of Chancery for an order to compel such inspection.").  

In considering the inspection request, the Chancery Court took into account that the plaintiffs had simultaneously filed a derivative suit.  The filing of the suit rendered the information sought in the inspection request unnecessary.  As the Chancery Court determined:

As a general matter, by filing its derivative complaint, Central Laborers acknowledged -- if, for no other reason than to satisfy its lawyers' rule 11 obligations -- that it had sufficient information to support its substantive allegations and its allegations of demand futility that would excuse prior demand on the News Corp. board -- both necessary to go down the path chosen by it to challenge the Proposed Transaction. In short, the stockholder plaintiff who files a Section 220 action immediately after its derivative action is acting inconsistently.

The trial court’s reasoning was neither based upon the purpose alleged by plaintiffs nor the paricular documents that could potentially be obtained.  It was a per se rule that the filing of a derivative action cut off the right to inspect.  The Supreme Court characterized the holding this way:  

the Court of Chancery held "[b]ecause Central Laborers' currently-pending derivative action necessarily reflects its view that it had sufficient grounds for alleging both demand futility and its substantive claims without the need for assistance afforded by Section 220, it is, at this time, unable to tender a proper purpose for pursuing its efforts to inspect the books and records of News Corp.”

The reasoning was arguably inconsistent with the holding in King v. Verifone Holdings, Inc., 12 A.3d 1140 (Del. 2011), where the Supreme Court held that the filing of a derivative suit did not cut off inspection rights.  The Chancery Court sought to distinguish the case.  Rather than address the issue, however, the Supreme Court affirmed the denial of the inspection demand but on entirely different grounds.  

The Court focused on the procedural aspects of an inspection demand, particularly the requirement in Section 220 that the demand “shall . . . be accompanied by documentary evidence of beneficial ownership of stock” and “shall be directed to the corporation at its registered office . . . “  The demand submitted by plaintiff contained a number of apparent errors.  See Central Laborers Pension Fund v. News Corp., 45 A.3d 139 (Del. 2012) (“First, the Inspection Demand identified the wrong corporation, stating that it seeks "to inspect and copy the . . . books and records of Viacom and its subsidiaries," rather than that of News Corp.  Second, the supporting materials filed in support of the Inspection Demand were inconsistent", with one affidavit referring to 14,110 shares beneficially owned and another to 14,110 shares owned as record owner). 

But the discussion of these “errors” was mostly gratuitous.  Only one mistake really mattered.  The Court focused on the fact that the demand did not include the account statements that established  beneficial ownership.  The affidavit submitted with the demand referred to an “annexed document” but did not have the "annexed document" attached.  Plaintiff described the failure as a “clerical error” and submitted a revised affidavit and the account statements with the brief opposing the motion to dismiss. 

Despite the fact that there appears to have been no serious doubt about the ownership of the shares and despite the fact that the company at issue had five business days to raise the missing attachent, the Court found that the omission was a sufficient basis for denying shareholders the right to inspect.  The statute, in the eyes of the Court, required that the documentary evidence of ownership be delivered with the demand, not later in the process. 

Having not done so, according to the Court, Plaintiff had to redeliver the entire demand, with the requisite attachments.  Delivering the omitted attachment once litigation had commenced wasn’t good enough.  Id. (“The statute requires the documentary evidence to accompany the demand for inspection. Therefore, Central Laborers' subsequent filing would comply with the statute only if it was submitted with either a new or an amended demand, directed at News Corp’s registered office or principal place of business. That was not done here.”).   

The holding elevates process to an untenable level.  The Court made no mention of the requirement that the company respond within five business days (which it did not, according to the complaint).  Had the company responded, it could have requested the requisite account statements rather than doing so after litigation had commenced.  The holding provides companies with an incentive to withhold procedural concerns over inspection demands until after litigation has been commenced.  In doing so, companies can use the concerns as an affirmative defense in the litigation.

It is an inefficient and rigid view of the statute.  Moreover, it is a decision that decidedly favors management (no penalty for failing to respond within five days) over shareholders (for failing to include the requisite attachment).     

Primary materials on this case are posted on the DU Corporate Governance web site


The Captive Employee Debate (Part 2)

Last week I blogged about the “captive employee” problem (here).  Paul Secunda has described the problem (here) as follows:

[A] lesser-known consequence of [Citizens United] might have a significant impact in the workplace: it may permit employers to hold political captive audience workplace meetings with their employees. Under Citizens United’s robust conception of corporate political speech, employers may now be able to compel their employees to listen to their political views at such meetings on pain of termination.

Stephen Bainbridge took issue with some of my conclusions (here), and I would like to use this week’s post to respond to some of his comments.  Bainbridge first asks:

[H]ow is this different from a union telling its members how to vote? Or, for that matter, the UC system sending me emails about how the world will end if Prop 30 doesn't pass? The notion that a business can't tell its employees that elections have consequences strikes this observer as absurd, not to mention a gross infringement on First Amendment rights. Should the First Amendment really be interpreted as giving pornographers more rights than employers?

I believe it is fair to say that there is a meaningful difference between receiving an email informing the reader of the possible economic consequences of a particular referendum passing, and having one’s employer effectively say, “I will fire some of you if Obama is elected.”  The connection between messenger and executioner in the latter case provides, I believe, a valid basis for distinction.  Furthermore, I believe there is a meaningful difference between receiving an email and being forced to choose between sitting for hours listening to political propaganda or being fired.  In both cases, I believe the threat of termination emanating from one's employer implicates the integrity of our voting system in a way the examples Bainbridge cites are less likely to.  Obviously, there is an empirical question lurking here, but it seems reasonable to assume that threats of termination may coerce people to vote differently than they otherwise would.   This implicates a state interest sufficient to warrant at least some infringement on the employer’s free speech rights, if not a need to recognize an employee’s right not to listen to unwanted political speech.

Bainbridge next complains that:

[B]laming the corporate form is particularly inapt. If the issue is employer pressure on employees, that issue exists regardless of the legal structure of the employer. If you think employers shouldn't be telling employees how government regulation affects business, shouldn't you want to restrict employer speech regardless of whether the employer is structured as a corporation, partnership, or sole proprietorship? Indeed, if we really are living in the age of the uncorporation, as my late friend Larry Ribstein used to argue, growing numbers of employers will be unincorporated. Corporate personhood and Citizens United thus are nothing but red herrings in this debate.

Given that much of the captive audience debate revolves around the First Amendment, it is hard to see how Citizens United can be deemed nothing but a red herring.  I fully expect Citizens United to be one of the first opinions corporate employers cite when confronting state laws seeking to restrict their rights in this area.  Furthermore, corporations are different.  As President Nicholas Murray of Columbia University said in 1911: “I weigh my words when I say that in my judgment the limited liability corporation is the greatest single discovery of modern times . . . . Even steam and electricity are far less important than the limited liability corporation, and they would be reduced to comparative impotence without it.”   My particular focus here is that employers should not be able leverage the unique economic power of the corporate form to attempt to coerce employee’s to vote a certain way.  As I mentioned in my original post: “These business owners were not granted the right to operate in the corporate form so they could pressure employees to vote for particular candidates.  Rather, they were granted the right to operate in the corporate form because of legislative judgments that making incorporation widely available would benefit society as a whole.”  Furthermore, I believe the justifications for this position likely extend to all limited liability entities.  Thus, while I agree with what I believe to be part of Larry Ribstein’s claim regarding the value of a shift to the uncorporation—that is, more skin in the game for managers--I highly doubt a growing numbers of employers will be giving up the state-granted benefit of limited liability any time soon.

Finally, Bainbridge wonders:

[E]ven if you think that incorporation is a privilege, wouldn't restrictions on the speech of senior management be an unconstitutional condition?

I am still in the early stages of getting my head around the unconstitutional conditions doctrine, so I am certainly open to being further educated on this point.  However, what I have learned about the doctrine to this point suggests that it is not nearly as effective a trump card as defenders of corporate political speech think.  I believe one can understand the unconstitutional conditions doctrine (which effectively prohibits the government from impairing constitutional rights indirectly by conditioning the receipt of certain government benefits on a waiver of those rights) as standing in opposition to the greater power doctrine (which provides that the greater power to deny a benefit necessarily includes the lesser power to condition the benefit).  In trying to resolve the seemingly insurmountable tension between these two doctrines, one may be able to look to the concept of germaness, which posits that a condition may be imposed if it is germane to the purpose of granting the benefit.  If this analysis is correct, then I would personally welcome an unconstitutional conditions challenge because one of the primary goals of my scholarship these past few years has been to get people to talk more about the purpose of granting corporate status in deciding First Amendment cases involving corporations.  (For an example, go here.)  At the very least, there seem to be some very legitimate arguments that can be made to tie the regulation of a corporation’s ability to use corporate assets to influence elections to the purposes underlying the grant of corporate status in the first place.  (Please send comments on this point directly to me at, because I sometimes miss the comments that are entered below the posts.)


Caps on the Size of Big Banks: Another Voice Weighs In

We've discussed the issue of bank regulation on this blog from time to time.  With a handful of banks holding the lions share of the assets in the financial system, the problem of too big to fail remains in place.  Two broad solutions exist.  One is to downsize the large financial institutions so that they are not too big to fail.  The approach is complex.  No one really knows what the optimal size of a bank should be.  Moreover, there is no particular agreement on the method.

The other is to impose additional prudential requirements designed to reduce the risk of failure.  The banks will still be too big to fail but will be less likely to fail.  The Volker Rule is an example of regulation in this category.

Daniel Tarullo, a government of the Federal Reserve Board, has weighed in on this issue.  He has called for limits on size (the speech is here).  Specifically, he has called for a limit on total non-deposit liabilities.  As he proposed:

The idea along these lines that seems to have the most promise would limit the non-deposit liabilities of financial firms to a specified percentage of U.S. gross domestic product, as calculated on a lagged, averaged basis. In addition to the virtue of simplicity, this approach has the advantage of tying the limitation on growth of financial firms to the growth of the national economy and its capacity to absorb losses, as well as to the extent of a firm's dependence on funding from sources other than the stable base of deposits.

In other words, banks would incur a limitation on their non-deposit sources of funding, effectively limiting their size.  According to the WSJ, Tarullo "is the highest ranking regulatory official to call for limiting the size of banks."

The approach raises plenty of questions, as Tarullo himself noted.

Of course, the difficult question would be the applicable percentage of GDP. The answer would depend on a judgment as to how much of an impact the economy could absorb. It would also entail a judgment as to how large and complex a firm needs to be in order to achieve significant economies of scale and scope that carry social benefit. Depending on the answers to these questions, there may be a need to balance the relevant costs and benefits. There would also be important secondary questions such as whether to exclude from a firm's calculated liabilities only insured deposits and which asset base to use in calculating non-deposit liabilities.

Whether these sorts of reforms will ever occur remains to be seen.  But it reflects a growing sentiment that the problem of too big to fail was not solved by the reforms in Dodd-Frank. 


The Fiduciary Limits on "Special Interest" Directors: Shocking Technologies v. Michael

One of the complaints about giving shareholders greater ability to nominate (and elect) their own candidates to the board is that they will elect "special interest" directors.  These are directors who are nominated by particular shareholders and who are expected to support the interests of the nominating shareholders rather than the interests of all shareholders. 

There are many many problems with this concern.  It ignores the need for the candidate to obtain support from other shareholders, something more difficult if the nominee looks like it won't represent the interests of all shareholders.  It also ignores the fact that directors have fiduciary obligations to all shareholders, not just those who submitted the nomination.

Fiduciary obligations to all shareholders, however, arguably provide reduced comfort given their amorphous nature.  Directors can favor almost any position (including those supported by the shareholder who submitted their nomination) and assert that it is consistent with fiduciary obligations.  Thus, to some degree, fiduciary duties do not impose meaningful limits on the behavior of individual directors. 

Shocking Technologies v. Michael, 2012 Del. Ch. LEXIS 224 (Del. Ch. Sept. 28, 2012), suggests that this may not be true.  The case did not involve a special interest director but did, nonetheless, clarify that there are substantial limits on the unilateral behavior of individual directors. 

In that case, the director at issue sat on the board of a start up.  A shareholder had the right to exercise warrants.  The exercise would, according to the court, provide the company with a much needed source of capital.  As the court described, the director "attempted to keep [the shareholder] from exercising the warrants in accordance with their terms and to persuade [the shareholder] to negotiate an even better deal—whether in terms of price or in terms of an additional board seat—before it exercised the warrants or made additional investments in Shocking."

The director's "actions clearly demonstrated a desire to interfere with the Company's funding."  The court viewed the behavior as disloyal.  See Id.  ("The best interests of the Company—finding enough cash to survive—were immediate and unmistakable. [The director], knowing the consequences if he was successful, acted against the Company's best interests. For that, he was disloyal.").  The court went on to conclude that the company had not shown damages.  In addition, the court declined to aware fees, finding an absence of bad faith. 

The court did not discount the right of directors to disagree or to seek to "change corporate governance ambiance and board composition."  Nonetheless, there were limits. 

A director may not harm the corporation by, for example, interfering with crucial financing efforts in an effort to further such objectives. Moreover, he may not use confidential information, especially information gleaned because of his board membership, to aid a third party which has a position necessarily adverse to that of the corporation.

The case stands for the broad proposition that fiduciary obligations impose limits on the behavior and activities of individual directors and require that director remain loyal to the corporation. 

In the context of "special interest" directors (not something present in this case), the decision suggests that directors nominated by a particular shareholder will be subject to claims of disloyal behavior if they overtly favor the nominating shareholder.  This significantly weakens the argument that directors nominated by particular shareholders will act in a manner that favors the nominating shareholder at the expense of the other owners. 


Severance, Waste and In re HP Derivative Litigation

We examined the law around severance packages paid to departing CEOs in the absence of an employment agreement in Seinfeld v. Slager.  The court in that case validated the payment on the basis of a general release and past service, justifications always present.  We noted that in Zucker, the Delaware Chancery Court essentially found that the amount paid as severance could not be challenged as waste where the board was independent and had used proper process.

The federal district court in In re HP Derivative Litigation, 2012 U.S. Dist. LEXIS 137640 (ND CA Sept. 25, 2012) largely made the same points. 

The litigation arose out of the departure of Mark Hurd as CEO from HP.  At the time of Hurd's departure, he had no employment agreement.  The board nonetheless executed a Separation Agreement that provided benefits allegedly valued at $53 million.  Plaintiffs alleged that the benefits constituted waste.  

The court, however, found that plaintiff had not adequately plead a claim for waste.  The court noted that a finding of waste was "inappropriate '[s]o long as there is some rational basis for directors to conclude that the amount and form of compensation is appropriate and likely to be beneficial to the corporation'".  The Separation Agreement contained "confidentiality, non-compete and non-solicitation covenants" clauses and provided for a waiver of claims. 

In discussing the waiver, court summarily dismissed claims by plaintiffs that the provision provided no meaninful benefit to the company. 

  • Plaintiffs' argument ignores that if the Board had not negotiated the terms of Hurd's departure and instead had fired him for cause or denied him severance, Hurd could have sued, bringing a claim for wrongful termination or violation of the Severance Plan. . . . The Release protected against the expense of litigation and negative publicity resulting from having to defend against such a claim. That is, even if the release was worth relatively little, Plaintiff overstates his case to say it was worthless.

Moreover, even without the consideration, "at least some portion of Hurd's severance could represent 'reasonable' compensation for his successful past performance."    

Plaintiff was, therefore, left with arguing that the amount paid was excessive.  Relying on the reasoning in Zucker, the court dismissed the claim. 

  • "[T]he size of executive compensation for a large public company in the current environment often involves large numbers," and "amount alone is not the most salient aspect of director compensation" for purposes of a waste analysis. Without question, the amount of Hurd's severance may appear extremely rich or altogether distasteful to some. But, "[t]he waste doctrine does not . . . make transactions at the fringes of reasonable decision-making its meat." Rather, "[t]he value of assets bought and sold in the marketplace, including the personal services of executives and directors, is a matter best determined by the good faith judgments of disinterested and independent directors, men and women with business acumen appointed by shareholders precisely for their skill at making such evaluations." Thus, allegations that the payments and benefits Hurd received were valued at approximately $53 million are alone insufficient to demonstrate waste. (citations omitted)

The analysis reiterated what Zucker had already made clear:  All severance arrangements with departing CEOs were supported by consideration and allegations of waste would not be allowed to go forward based upon the amount paid. 

In concluding that past consideration was sufficient to justify at least part of the severance, the court did not analyze or even note the compensation packages received by the departing CEO in the past.  According to the HP proxy statement filed in 2010, Hurd had received total compensation of $30 million in 2009, $42 million in 2008, and $25 million in 2007.  In other words, the court did not find it relevant to even examine prior pay packages before determining whether severance was appropriately paid for past performance to the company. 

The federal court in this case applied Delaware law.  The standard does not permit meaningful review of severance packages paid to departing CEOs.  As a result, the state law standard exerts no downward pressure on severance amounts.  Any effort to reduce amounts paid as severance will need to percolate up from Congress (see say on pay, clawbacks, and the regulation of Compensation Committees of exchange traded companies).


Waste, Severance, and importance of "Creative Counsel" -- Zucker v. Andreesen

Zucker is a case we have already discussed.  Go here, here and here.  Nonetheless, it is worth revisiting in connection with our discussion of the standard of review for severance packages.  We noted in Seinfeld v. Slager that the court all but held that past service to the board and general waivers would be sufficient to justify the payment of severance. 

Zucker arose out of the departure of Mark Hurd from HP.  Although not having an employment contract, he received severance benefits allegedly valued at $53 million.  The plaintiff challenged the payments as waste.  Plaintiff argued that the execution of a "waiver" was not sufficient consideration to justify the payments. 

Although the court found that plaintiff was entitled to a presumption that the court could have terminated the CEO for cause, the court found that "there is no allegation from which the Court reasonably can infer that Hurd necessarily would have acquiesced in such a decision."  Moreover, "[c]reative counsel advocating on Hurd's behalf could have claimed that he, in fact, was entitled to severance under HP's general executive officer severance plan notwithstanding the expense report violations."  As a result, while the board "might have prevailed," the company could have been required to "incur considerable costs of time, resources, and negative publicity in the interim."  

In other words, the argument that the waiver was worthless because it was the board that had possible claims, not the CEO, was rejected by the court out of hand.  It was enough that "creative counsel" could still find a way to file a claim (presumably while avoiding the risk of sanctions under Rule 11).  Moreover, irrespective of the value of the waiver, the company "arguably still could have compensated him for his past stewardship of HP."  

As for the argument that the amount was excessive, the court found that the amount was actually not the determining factor in a claim for waste.   

Plaintiff's waste claim reduces to his belief that $40 million was just too much. Be that as it may, "the size of executive compensation for a large public company in the current environment often involves large numbers," and "amount alone is not the most salient aspect of director compensation" for purposes of a waste analysis. Without question, the amount of Hurd's severance may appear extremely rich or altogether distasteful to some. But, "[t]he waste doctrine does not . . . make transactions at the fringes of reasonable decision-making its meat." Rather than by judicial predilection, "[t]he value of assets bought and sold in the marketplace, including the personal services of executives and directors, is a matter best determined by the good faith judgments of disinterested and independent directors, men and women with business acumen appointed by shareholders precisely for their skill at making such evaluations." 

In other words, even a "distasteful" payment would be upheld if the process used by the board was adequate. 

The case, therefore, stands for the proposition that severance packages paid to departing CEOs who do not have a compensation agreement cannot be challenged due to a lack of consideration and cannot be challenged because the amount is excessive.  In other words, the outer limits set by the waste doctrine in the context of severance agreements are no limits at all.  The Delaware courts, therefore, do not intend to impose any limits on these payments.  To the extent that limits are imposed, as we have noted earlier, they will have to be imposed by the federal government. 


Seinfeld v. Slager and "Limits" on Directors' Fees (Part 3)

We are discussing Seinfeld v. Slager, 2012 Del. Ch. Lexis 139 (Del Ch. June 29, 2012). 

The other issue that arose in Seinfeld was the decision by the board to grant itself "restricted stock units" under the company's stock plan.  According to the allegations, outside directors in 2009 received total compensation of between $843,000 and $891,000.  Of that amount, $743,700 came in the form of awards under a stock incentive plan "administered by administered by a committee of non-employee members of the Board or if no committee exists, by the Board itself."  As the court noted: "The Defendant Directors are participants in the Stock Plan, and pursuant to it have awarded themselves time-vesting restricted stock units."  

The Plaintiff challenged the fees as excessive.  In determining the standard of review, the court focused on the allegations that the directors had awarded themselves stock units under the stock plan.  A prior decision had found that even where this occurred, the applicable standard was the business judgment rule. 

Plaintiffs, however, argued that the plan lacked "sufficient definition to afford" directors the protections of the BJR.  The court agreed. 

The Stock Plan before me puts few, if any, bounds on the Board's ability to set its own stock awards. The Plan itself provides that the Committee, comprising the Directors themselves, has the sole discretion, in terms of restrictions and amount, over how to compensate themselves. In regard to restricted stock, the limitations upon the Board are that it can only award 10,500,000 shares total and award an Eligible Individual 1,250,000 shares a year. . . . Assuming that there were 12 directors, the Board could theoretically award each director 875,000 restricted stock units. At $24.79, the award to each director would be worth $21,691,250 and the total value would be $260,295,000.

Nor did shareholder approval change the outcome.  See Id.  ("A stockholder-approved carte blanche to the directors is insufficient. The more definite a plan, the more likely that a board's compensation decision will be labeled disinterested and qualify for protection under the business judgment rule. If a board is free to use its absolute discretion under even a stockholder-approved plan, with little guidance as to the total pay that can be awarded, a board will ultimately have to show that the transaction is entirely fair."). 

The lack of standards in the stock plan did not result in a finding that the fees were, in fact, excessive.  Instead, it imposed on the board the obligation to show fairness.  The board would still have an opportunity to show that the fees were not excessive in fact.  Nonetheless, the case was allowed to go forward.  

The decision did not portend any meaningful judicial review of directors fees or any meaningful downward pressure on the amount of fees.  The take away is simply that companies should include more meaningful limits on board discretion in stock plans.  To the extent boards are not in a position to award themselves shares or options that could be characterized as "excessive," the standard of review in Delaware is likely to remain the business judgment rule. 

Primary materials on the case have been posted at the DU Corporate Governance web site


Seinfeld v. Slager and the Non-Reviewability of Retirement Compensation (Part 2) 

We are discussing Seinfeld v. Slager, 2012 Del. Ch. Lexis 139 (Del Ch. June 29, 2012).

In Seinfeld, the board agreed to pay $1.8 million to a departing CEO in return for "long service to the company."  In other words, the payment was in return for past service.  This, the court found, was sufficient to demonstrate "value" received by the company.  

In doing so, however, the court did not focus on any unique facts.  Instead, companies always received value when providing payments in return for past services.  In the case of retiring employees, the benefit to the company could, for example, be the fact  

the award may serve as a signal to current and future employees that they, too, might receive extra compensation at the end of their tenure if they successfully serve their term. Other factors may also properly influence the board, including ensuring a smooth and harmonious transfer of power, securing a good relationship with the retiring employee, preventing future embarrassing disclosure and lawsuits, and so on.

These possibilities were enough.  There was no need for any actual evidence that this was the case. 

Perhaps aware of the lack of actual support for this analysis, the court found additional consideration for the payment by viewing the amount as part of the retirement package.  The general release provided by the CEO for the entire package was deemed sufficient to support the $1.8 million payment.  See Id.  ("The Retirement Agreement, considered as a whole, is clear from its explicit terms that it provided the cash bonus as part of a package intended to secure a general release, to provide continuity in the Board, and to ensure that O'Connor's separation from the Company was amicable."). 

The striking thing about the opinion was how little the actual facts of the case mattered.  The reasons used by the court to justify payments for past services were reasons that were present in every case. It could always be alleged that the payments would provide an incentive to existing employees to "serve their term" or to permit a "smooth" transition of a departing CEO.  Thus, the court essentially validated the use of past service as consideration in all cases. 

Moreover, the reasoning was questionable.  It was quite unclear whether voluntary payments to a departing CEO would provide any kind of "signal" to "current and future employees" other than the CEO.  Arrangements with the CEO -- whether generous or parsimonious -- likely provide no guidance as to how other employees will be treated. 

To the extent that the payments were intended to "serve as a signal" for future CEOs, the signal was likely to have little value.  A payment to one CEO would not support a conclusion that a future CEO would be treated in an identical fashion.  Boards and circumstances change.  Moreover, if the goal was to ensure that the CEO completed his or her term, the board (and the CEO) had a more certain mechanism -- the employment contract.  Severance in an agreement was much more likely to achive the goal of term completion than the need to read "signals" based upon the treatment of past CEOs.   

The use of a general release to support consideration provided another basis for upholding severance payments in all cases, irrespective of the specific facts.  Indeed, the court ignored the fact that the board had specified the reasons for the payment -- past service to the company -- and concluded that the payments were also supported by any consideration connected to the retirement package as a whole.  The court made no attempt to analyze the particular waiver to determine whether in fact it provided the company with any meaningful value. 

The use of past service and general releases to sustain severance packages means that they can no longer be challenged in Delaware as unsupported by consideration.  The "benefits" given by the court that arise from payments for past service are always present (as is a waiver).  After this case, the only way a severance package can be challenged as waste is by alleging that the amount is excessive.  Subsequent cases show that this is avenue has also been more or less foreclosed by the Delaware courts. 

In short, meaningful limits on severance payments will have to be imposed at the federal level.  Congress has already recognized this.  Say on pay provides an advisory vote on some golden parachutes.  With cases such as Slager, pressure could arise for additional federal intervention.  

Primary materials on the case have been posted at the DU Corporate Governance web site.


Seinfeld v. Slager and the Non-Reviewability of Retirement Compensation (Part 1) 

Seinfeld v. Slager, 2012 Del. Ch. Lexis 139 (Del Ch. June 29, 2012) is an example of the Delaware appraoch to compensation.  The case illustrates some of the reasons why compensation decisions have increasingly become a matter of federal rather than state oversight.  

In providing for the review of CEO compensation, Delaware courts do not take into account the interested influence of the CEO inside the board room.  In public companies, CEOs almost always sit on the board.  Nonetheless, the standard of review for CEO compensation is usually the duty of care rather than the duty of loyalty.  As a result, challenges are mostly limited to the process used in approving the compensation, with the amount and terms of the pay package essentially irrelevant to the analysis. 

The extent to which courts render compensation decisions, particularly severance packages, unreviewable under this standard was made clear in Seinfeld v. Slager, 2012 Del. Ch. Lexis 139 (Del Ch. June 29, 2012).  In that case, the CEO had served for ten years.  Although he had no employment contract, the board executed a retirement agreement.  As part of the agreement, he received $1.8 million in cash for his "long service to the Company."  Shareholders challenged the payment, asserting that it was not supported by consideration. 

The Delaware court defined the appropriate standard as the business judgment rule.  See Id.  ("Employment compensation decisions are core functions of a board of directors, and are protected, appropriately, by the business judgment rule.").  That left shareholders with the "a Herculean, and perhaps Sisyphean, task" of establishing that the payment was waste. 

Waste typically connotes payments made by the company in return for no benefit.  A shareholder might claim that a payment was unsupported by consideration and therefore resulted in no value to the company.  Alternatively, a shareholder might argue that the payment was excessive.  

In Seinfeld, the issue was whether the payment was supported by consideration.  Because of the characterization given by the company, the court had to decide whether past service was sufficient to provide the necessary consideration.  Moreover, the court confronted past cases suggesting that it was not.  Nonetheless, the court essentially concluded that past service to the company was always consideration. 

We will look at the court's reasoning in the next post. 

Primary materials on the case have been posted at the DU Corporate Governance web site.


Continued Erosion of the Blasius Standard: Keyser v. Curtis (Part 2)

We are discussing Keyser v. Curtis.  In that case, the Chancery Court opted to apply entire fairness from the duty of loyalty rather than the compelling justification standard dictated by Blasius

The court's interpretation amounted to a limit on the Blasius standard, rendering it inapplicable to circumstances implicating the duty of loyalty.  In reaching the conclusion, the court made a number of questionable assertions. The court characterized the standard as an intermediate one, thereby viewing the application of fairness as a stricter standard.  See Id. (main role of Blasius is as "a specific iteration of the intermediate standard of review laid out in Unocal Corp. v. Mesa"). 

For one thing, Blasius is not an "intermediate" standard.  Intermediate standard is usually used to describe a standard that falls between the duty of care and the duty of loyalty.  Unocal is an intermediate standard.  See Air Prods. & Chems., Inc. v. Airgas, Inc., 16 A.3d 48 (Del Ch 2011)  ("Because the Airgas board is taking defensive action in response to a pending takeover bid, the "theoretical specter of disloyalty" does exist—indeed, it is the very reason the Delaware Supreme Court in Unocal created an intermediate standard of review applying enhanced scrutiny to board action before directors would be entitled to the protections of the business judgment rule."). 

Blasius, on the other hand, is an enhanced standard.  See MM Cos. v. Liquid Audio, Inc., 813 A.2d 1118 (Del. 2003).   Indeed, the compelling justification is likely more difficult for the board to show than the traditional fairness analysis required by the duty of loyalty. 

Nor was Blasius a specific iteration of Unocal.  The only authority for that proposition cited by the court was Mercier, a case that called for the abandonment of Blasius in favor of Unocal, and an article making essentially the same point. Moreover, in MM Cos. v. Liquid Audio, Inc., 813 A.2d 1118 (Del. 2003), the Supreme Court had an opportunity to equate the two standards but did not.  Instead, the Court found that "the special import of protecting the shareholders' franchise within Unocal's requirement that any defensive measure be proportionate and 'reasonable in relation to the threat posed.'"

There is a reason why the two standards are not the same.  Unocal is a significantly lower standard than Blasius and merely requires a showing of reasonableness.  Under the approach, boards could impair the franchise if reasonable.  Because courts routinely defer to the board's decision on reasonableness, the standard in reality gives management almost unlimited discretion to act so long as the process is proper.  Certainly this was made clear in the Air Products decision.  The net effect of a reasonableness standard would be to give shareholders substantially less protection that what is currently provided in Blasius.  

Indeed, the court in Keyser suggested that it would be enough to sustain the actions of the board by showing "fair dealing."  See Keyser ("because [the director's] self-dealing was motivated by a desire to prevent [the company's] shareholders from electing a new Board—a motive that is inherently suspect under Delaware law—the Defendants must show that [the director] undertook a considerably robust process in order for the Court to come to the conclusion that [director's] actions were entirely fair.").  In other words, compelling justification would be replaced with proper process.

Of course, the recognition by the Chancery Court that boards would need to employ a "considerably robust process" was an acknowledgement that in fact the traditional "entire fairness" analysis required by the duty of loyalty was not good enough to ensure the protection of the franchise.  As a result, the court was effectively calling for a higher standard of entire fairness.  Yet this "higher" standard was decidedly lower than compelling justification.

For awhile, Mercier stood alone in seeking to transform the Blasius standard into a reasonableness analysis.  Keyser ended the isolation.  The Supreme Court will eventually have to intervene.  When it does, the presumption of the race to the bottom suggests that it will side with the Chancery Courts and effectively replace the Blasius standard with a more management friendly approach.  

Primary materials in this case are posted on the DU Corporate Governance web site.


Continued Erosion of the Blasius Standard: Keyser v. Curtis (Part 1)

Shareholders get few meaningful protections under Delaware common law.  One of them has been the Blasius standard.  Blasius has held that actions taken in order to prevent the proper exercise of the franchise by shareholders must be supported by a "compelling justification."  The court in Blasius came to the conclusion that these matters were not appropriately reviewed as a matter of business judgment but deserved a higher standard of review. 

Blasius has been applied in cases where directors filled board vacancies or changed the date of a shareholder meeting.  In other words, it applies to what otherwise would be routine functions of the board.  It is the motive of the board that takes the actions out of the routine.  The standard is sufficiently high that, once the courts have found the Blasius standard to be applicable, boards have had a difficult time showing the requisite compelling justification.  Only one case so far has held that the board met this standard.  See Mercier v. Inter-Tel, 2007 Del. Ch. Lexis 119 (Del. Ch. 2007).  

There is, however, growing opposition to the Blasius standard in the Chancery Court.  In Mercier, the court argued that the applicable analysis should be the reasonableness standard from Unocal.  Since the "reasonableness" standard in Unocal is an easy one to meet, the effect of the change would be to reduce the protections afforded shareholders and give management greater latitude to interfere with the franchise.

In Keyser v. Curtis, 2012 Del. Ch. Lexis 175 (Del. Ch. July 31, 2012), the erosion of the Blasius standard in the Court of Chancery continued.  The case involved allegations that the sole director of the company created a class of Series B shares, each with 1000 votes and each redeemable (at the demand of the holder) for $1.00.  The director purchased 25,000 shares for $0.01 per share.  As the court reasoned, the shares were issued "in order to prevent [the insurgent] and his allies from electing a new Board, which is the quintessential Blasius trigger." 

Given that the case implicated Blasius, the applicable standard of review ought to have been the compelling justification standard.  The court, however, decided otherwise.  It first noted that the "main role" of the Blasius standard, "to the extent it has one," was "as a specific iteration of the intermediate standard of review laid out in Unocal Corp. v. Mesa Petroleum Co."  The court went on to conclude that in cases involving self interested transactions, such as the one at issue, "[a] standard of review that was established to review selfless conduct is, by definition, ill-suited to serve as a standard of review for self-dealing conduct."  As a result, the court opted to apply the entire fairness doctrine.  

We will discuss the implications of this decision in the next post.  

Primary materials in this case are posted on the DU Corporate Governance web site.


A Delaware Update

This week (and maybe some of next), we will be reviewing a series of Delaware cases.  The decisions are varied. 

There are a handful that push the law in an interesting direction.  The decisions by VC Laster that seek to affect the race to the courthouse fall into this category.  There are a host of additional decisions that reflect the management friendly nature of the Delaware courts.  Decisions on inspections right and the application of the Blasius standard fall into this category.


Is this what states created corporations for?

You may have heard the stories making the rounds this week about employers pressuring their employees to vote for particular candidates.  Much of this activity apparently traces back to Mitt Romney expressly encouraging business owners to do this.  As reported (here):

The candidate himself suggested that business owners adopt this practice during a virtual town hall meeting with the National Federation of Independent Businesses back in June.  “I hope you make it very clear to your employees what you believe is in the best interest of your enterprise and therefore their job and their future in the upcoming elections," he said, telling the audience, "Nothing illegal about you talking to your employees about what you believe is best for the business, because I believe that will figure into their election decision, their voting decision."

Personally, I think a number of the reported tactics rise to the level of an abuse of power.  At least to the extent these are corporate employers, my rationale is:

1.  The leverage used on these employees is at least partly attributable to the corporate form.  That is to say, without the capital accumulation benefits of corporate status, the owners of these businesses would likely not have nearly as much power to exert over this captive audience of employees.

2.  These business owners were not granted the right to operate in the corporate form so they could pressure employees to vote for particular candidates.  Rather, they were granted the right to operate in the corporate form because of legislative judgments that making incorporation widely available would benefit society as a whole.  (If you believe that it is possible to create a corporation solely via private contracting, then this point will be unconvincing to you.  However, please let me know if you ever actually manage to pull off that feat.)

3.  Given this public aspect of corporate status, it is improper to divert the power of this corporate form to force the business owner’s personal political views on employees.

However, as Paul Secunda explains (here), as a result of Citizens United such abuses of power are now legal.

Citizens United has wrought widespread changes in the election law landscape. Yet, a lesser-known consequence of this watershed case might have a significant impact in the workplace: it may permit employers to hold political captive audience workplace meetings with their employees. Under Citizens United’s robust conception of corporate political speech, employers may now be able to compel their employees to listen to their political views at such meetings on pain of termination….

Prior to Citizens United, the 1971 Federal Election Campaign Act (FECA), as amended in 1976, provided that corporations were permitted unlimited communication with and solicitation of shareholders and executive and administrative personnel (the corporation’s “restricted class”). Rank-and-file employees, on the other hand, could be solicited for corporate Political Action Committees (PACs) only twice a year (originally pegged to primary and general election seasons), only by mail sent to their home addresses, and only through an accounting system that made it impossible for management to know which employees did or did not contribute. Partisan political communication to rank-and-file employees, moreover, was completely prohibited.

Now, post-Citizens United, express advocacy outside a corporation’s restricted class is no longer restricted….

Although federal law does still prevent employers from issuing explicit or implicit threats against employees who vote for the “wrong” candidate, short of that, nothing prohibits employers from requiring employees to participate in one-sided political propaganda events.


S.E.C. v. Stoker: Court Denies Citigroup Director’s Motion to Dismiss Claims under Sections 17(a)(2) and (3) of the Securities Act of 1933  

In S.E.C. v. Stoker, No. 11 Civ. 7388(JSR), 2012 WL 2017736 (S.D.N.Y. June 6, 2012), the Southern District of New York reaffirmed its earlier order denying defendant Brian Stoker’s motion to dismiss after concluding that the Securities and Exchange Commission (“SEC”) adequately stated claims for relief under the Securities Act of 1933.  The SEC alleged that Stoker, in his capacity as director in a division of Citigroup, negligently violated §§ 17(a)(2) and (3) of the Securities Act of 1933. 

Citigroup Inc.’s primary broker-dealer is Citigroup Global Markets Inc. (“Citigroup”). Brian Stoker was a Citigroup director responsible for constructing and marketing securities known as collaterized debt obligations (“CDOs”), and, specifically, the Class V Funding III (the “Fund”).  Section 17(a)(2) prohibits “obtain[ing] money or property by means of any untrue statement [or omission] of a material fact [in connection with the sale of securities].”  Furthermore, subsection (3) prohibits “engag[ing] in a course of business which operates … as a fraud or deceit upon the purchaser [in connection with the sale of securities].”  The SEC alleged that Stoker negligently violated both subsections because he was responsible for ensuring the accuracy of the marketing materials that were sent out to potential CDO investors.

Stoker made two arguments as to why the SEC’s claim that he violated § 17(a)(2) should be dismissed.  First, Stoker conceded that his bonus increased “around the time of the fraud,” but he argued that the two occurrences were not sufficiently linked to qualify under § 17(a)(2).  The court reasoned that under a plain reading of the statute, § 17(a)(2) imposes liability where the benefit is obtained either “directly or indirectly.”  Therefore, it was sufficient that Stoker, acting as an agent of Citigroup, facilitated a fraud, which made Citigroup millions of dollars by means of  “…untrue statement[s] of a material fact or any omission[s].”  The court then concluded that the SEC’s allegations were enough to impose liability regardless of whether Stoker obtained compensation for his employer, or if Stoker himself financially benefited indirectly from the fraud.

Next, Stoker argued the SEC failed to allege that he be held solely responsible for “making” the omissions and false statements contained within the marketing materials.  Stoker analogized the “by means of” language of § 17 to the “to make” language in Rule 10-b5 of the Securities and Exchange Act of 1934.  The court reasoned that § 17(a)(2), unlike Rule 10-b5, imposes liability where money or property is obtained “by use of a false statement,” regardless of the source.  Alternatively, Stoker argued that the court should apply the KPMG standard, which requires plaintiffs to argue that the actor was “sufficiently responsible for the statement … and knew or had reason to know that the statement would be disseminated to investors.”  The court found that even this more stringent KPMG standard was met; Stoker made “substantial edits” to the marketing materials given to investors, and he knew the statements included in the marketing materials would be given to investors.

Lastly, Stoker argued that the SEC’s § 17(a)(3) claim is duplicative of the § 17(a)(2) claim. A defendant may be held liable under both subsections, so long as the plaintiff alleges that the defendant “undertook a deceptive scheme or course of conduct that went beyond the misrepresentations.”  The court found that the misrepresentations and omissions within the marketing materials constituted a portion of the alleged misconduct, but not the entirety of it.  Stoker and Citigroup were on notice that certain CDOs were going to perform poorly, but they sought to include as many of these assets in the Fund as possible.  Furthermore, the two engaged Credit Suisse Alternative Capital as their collateral manager, knowing investors would not be interested in the Fund unless they thought a reputable third party would choose the assets.  Finally, they represented to one particular investor that the Fund was a “top-of-the-line CDO squared.”  The court found this more than sufficient to state a claim under § 17(a)(3). 

After this decision, the case went to trial on July 31, 2012 and the jury acquitted Stoker.  The SEC was unsuccessful in proving that Stoker was primarily responsible for the perpetrated fraud, primarily because Stoker’s lawyer, John Keker, successfully questioned why Stoker, a relatively low-level executive was targeted by the SEC instead of the CEOs in decision-making levels above him.

The primary materials for this case may be found on the DU Corporate Governance website.  


Turtles All the Way Down: Rulemaking, the DC Courts, and the Lack of Judicial Deference

The latest legal challenge to an SEC rule is underway.  The Chamber of Commerce and the American Petroleum Institute have challenged the SEC's rule governing payments by mineral extraction companies.  The complaint in the district court and the petition in the court of appeals contains a first amendment challenge.  (The action has been filed in the district court and in the court of appeals, with an emergency motion pending in the court of appeals that seeks to resolve jurisdiction). The complaint also alleges that the SEC exceeded its rulemaking authority. 

The complaint asserted that the SEC's "principal defense" of the "onerous rule" was "that it was required by law to issue the rule it adopted, under Section 1504 of the Dodd-Frank Wall Street Reform and Consumer Protection Act."  The complaint characterized the defense as "mistaken" and argued that the SEC lacked the rulemaking authority to adopt the rule.

Section 1504 requires only that a “compilation” or aggregation of payment information made by all U.S. companies to each foreign government and the federal government be made publicly available. The Commission, however, grossly misinterpreted its statutory mandate to require that each U.S. company publicly file a report on the Commission’s online electronic database (EDGAR) detailing each payment made to each and every foreign government, for each and every “project” relating to extractive industries. And the Commission adopted this approach despite the fact that publication of a “compilation” would have served the purposes of the statute without further burdening U.S. companies or revealing trade secrets or pricing strategies to competitors.

Mostly, though, the complaint and the petition repeated the basis used by the DC courts to justify their interventionist approach with respect to agency rulemaking.  The SEC, as usual, failed to conduct an adequate cost benefit analysis. 

the Commission failed to properly consider the Rule’s effects on competition, or whether the Rule was likely to achieve its desired benefits in light of its enormous costs. Indeed, the best the Commission could muster as to the Rule’s purported benefits was that it “may result in social benefits” that “cannot be readily quantified with any precision.” 77 Fed. Reg. at 56, 398 (emphasis added).

The actual cost benefit analysis applied by the Commission was little more than "lip service." 

While the Commission paid lip service to the requirement for cost-benefit analysis and tabulated (erroneously) some of the direct costs of the Rule, it repeatedly failed to resolve critical questions that directly relate to the Rule’s effect on competition; made regulatory choices that exacerbated the competitive harm to U.S. companies and increased the burden on First Amendment rights; and flatly refused to allow any exemption from the Rule’s requirements to protect U.S. companies from the billions of dollars in competitive harm it projected.

Part of the "arbitrary" beavior was the decision not adopt certain exemptions. 

In the final Rule, the Commission arbitrarily rejected any exemption from the Rule’s disclosure requirements for projects in countries that forbid such disclosures by law. 77 Fed. Reg. at 56,368. That refusal flies in the face of principles of comity and the Restatement (Third) of Foreign Relations Law, both of which counsel against implementing a statute in a manner that causes a direct conflict with foreign law.

In the past, this would have been viewed as a long shot.  There are two things that make it a more viable challenge.  First, it was filed by Eugene Scalia.  He has an enviable track record in the DC courts with respect to challenging agency rulemaking. 

The other is a decidedly interventionist set of courts in the DC Circuit (although Scalia pointedly disagrees with this approach).  Its true that SEC rules have been invalidated by panels that include judges appointed by presidents of both parties.  But the decision in the shareholder access case was, as we have noted on this blog, not well reasoned and explained more by a dislike for shareholder access than an analysis of administrative law.  It reflected an utter lack of deference to agency process, something traditionally required under the arbitrary and capricious standard of review.  See Shareholder Access and Uneconomic Economic Analysis: Business Roundtable v. SEC

The same is risk is present in this case.  To the extent the judges do not like the rule (despite the congressional mandate that it be adopted), they will strike it down on the basis of an inadequate cost benefit analysis.  Since this type of analysis is not subject to definitive standards, a court can always find that it was inadequate. 

The approach has long term costs.  In addition to the consequences with respect to the particular rule, the interventionist approach of the courts discourages rulemaking in the first instance and discourages anything but the most conservative approach to rulemaking in the second. 

In many cases, this does not obviate regulation.  It merely shifts regulation from rulemaking to informal positions of the staff.  Informal positions, as we have noted, are subject to far greater swings as the political makeup of the Commission changes.  See Essay: The Politicization of Corporate Governance: Bureaucratic Discretion, the SEC, and Shareholder Ratification of Auditors.  One set of costs simply replaces another. In short, turtles all the way down

We will follow the case.  The complaint is posted on the DU Corporate Governance web site. 


Going the Way of the Dodo: CFOs on the Board of Directors

The WSJ recently discussed the disappearance of the CFO from the board of directors of large public companies.  In fact, the disappearance was nothing new.  As the article noted, the number of CFOs on the board of Fortune 500 companies had declined from 37 in 2005 to 19 in 2012.  While this represented a 50% decline, it also represented a fall from a meager 8% to an even more meager 4%.  In other words, CFOs have been a rare presence on the board for a significant period of time. 

In fact, the trend has been less about the CFO and more about the general decline of all non-independent directors.  According to a study of the 100 largest public companies by the law firm Shearman & Sterling, 93 of the companies  have a board with at least 75% independent directors and on 56 of the companies, the CEO is the only non-independent director.  In other words, the trend in board composition of the largest companies is to have all independent directors except for the CEO.

The WSJ article further noted that "[g]overnance advocates, of course, back the idea of fewer CFOs serving on their respective company's board."  But in fact it is not that simple.  The article left out another critical fact.  As the Shearman & Sterling Report determined, 71 of the 100 largest companies combine chair of the board and CEO.  Only 12 companies have an independent director serving as chair. 

In other words, the largest boards consist of independent directors with the CEO serving as chair.  Independent directors are for the most part directors with no significant relationship with the company.  As a result, the CEO is the only director on the board with detailed knowledge about the internal activities of the company.  This provides a certain degree of control over information.  By serving as the chair, the CEO also determines the agenda of the board meeting and the information that will be provided to directors. 

The presence of the CFO or any other executive officer on the board provides an additional source of information for independent directors.  In other words, there is a benefit that can flow from the presence of executive officers inside the boardroom.  Moreover, the benefit is likely to be greater where the CEO serves as chair.   

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